Increasing Short-termism?

Source:

Maybe Companies Aren’t Too Focused on the Short Term

Evidence and Implications of Short-termism in US Public Capital Markets: 1980-2013

A Long Look at Short-Termism Questioning the Premise

 

Last week when we went through Montier’s criticism about shareholding value maximization, one thing we mentioned is “given the shortening lifespan of a corporate and the decreasing tenure of the CEO, many managers are willing to sacrifice long-term value for short-term gain”. The most fact that Monteir found is “declining and low rates of business investment.”

However, this week Tyler Cowen wrote an article to defend the short-termism.

First of all,

“Short-termism is said to plague all parties in the investment community, including investment managers, companies, and investors. However, it is very difficult to prove.”

However, a recent paper claims to “provide evidence of increasing short-termism in US equity capital markets over the period of 1980-2013, by using a ‘market discount factor’ estimated for publicly traded firms based on a capital asset pricing model”. (Which means it’s also a study for valuation.)  They find that “markets more heavily discount firms that have less financial slack, spend less on capital or R&D, have greater analyst coverage, or held by more transient institutional investors as well as pay their executives via more short-term compensation.And “short-term market valuations are significantly negatively correlated with future capital investment. “

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-09-23-35-30

However, Cowen argued that American corporations ought to be on short-term.

The following reasons are also combined with ideas from Michael J. Mauboussin’s report.

 

1. In information technology, betting on the future feels imprudent if change is rapid.

Academic research shows that the period of competitive advantage is shrinking for companies.

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-09-23-40-24

The world is speeding up. If the sustainability of a company’s economic profit is fleeting, there is less reason to place great value on the future. Planning so far out can involve a lot of expense and risk.

2. In information technology, the average life of a corporate asset is lowering.

“Production has shifted toward service sectors with relatively short asset lives, and that may call for a shorter-term orientation in response.”

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-09-23-56-25

Except rapid change, the more actual effect on investment comes from balance sheet, since shorter asset lives means higher depreciation.

-> So for many companies a contraction in time horizon is a proper response to economic reality.

And this is backed by “corporate governance tends to be better in sectors where asset lives are long than in sectors where asset lives are short. Where monitoring long-term investments is most relevant, corporate governance is the best developed. “

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-10-2-13-12

3. Companies tend to make big mistakes from thinking too big and too long-term

“for instance, a lot of mergers were based on notions of long-run synergies that never materialized.”

4. Given to high endurance of losing money by startups, investors are not ignoring the long-run prospects of the company.

“Amazon has a high share price even though its earnings reports have usually failed to show a profit .Many tech startups have high valuations even though revenue is zero or low.”

“During the dot-com bubble of the 1990s, there was too much long-run, pie-in-the-sky thinking and not enough focus on the concrete present.”

5. Compensation schemes for managers are more complex and more varied than in the past.

“Executive compensation has moved toward long-term incentives, boards of directors are more independent than in the past, and governance committees are “nearly universal.”

Moreover, a link between pay and short-termism is difficult to establish.

<- Academic research shows that CEO pay has closely followed the size of the firms in the economy independent of the form of remuneration.

6. Transient investors are not increasing.

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-10-2-20-20

And “while transient investors do take a short view, they are attracted to companies that provide lots of information events. It is these companies that appear most willing to trade value-creating investments to deliver short-term results.”

 

Anyway, “If public shareholders are placing too much short-term pressure on their companies for a good quarterly earnings report, companies have the option of boosting their value by going private, as has been the trend.”

<- By 2012, the number of U.S. public corporations was less than half what it had been in 1997, in part because many companies went private. See here.

 

Update 2017/10/21

Are U.S. Companies Too Short-Term Oriented? Some Thoughts Steve Kaplan University of Chicago Booth School of Business

Advertisements

SVM, The Dumbest Idea In The World

Source:

The Dumbest Idea In The World: Maximizing Shareholder Value

The World’s Dumbest Idea

 

There is only one valid definition of a business purpose: to create a customer. -Peter Drucker

Roger Martin had a fabulous analogy about shareholder value maximization (SVM) and baseball.

“Imagine an NFL coach, holding a press conference on Wednesday to announce that he predicts a win by 9 points on Sunday, and that bettors should recognize that the current spread of 6 points is too low. Or picture the team’s quarterback standing up in the postgame press conference and apologizing for having only won by 3 points when the final betting spread was 9 points in his team’s favor. While it’s laughable to imagine coaches or quarterbacks doing so, CEOs are expected to do both of these things.”

And Steve Denning added

“Imagine also, to extrapolate Martin’s analogy, that the coach and his top assistants were hugely compensated, not on whether they won games, but rather by whether they covered the point spread…Suppose also that in order to manage the expectations implicit in the point spread, the coach had to spend most of his time talking with analysts and sports writers about the prospects of the coming games and “managing” the point spread, instead of actually coaching the team…Looking at these forty-eight games, one would be tempted to conclude: “Surely those scores are being ‘managed’?””

The story began from Jack Welch. In an interview in the Financial Times from March 2009, Welch said “Shareholder value is the dumbest idea in the world.”

Next part we basically follow James Montier’s paper

 

The origin of SVM

SVM was found under some idea that in the presence of ubiquitous perfect competition and fully complete markets, a Pareto optimal outcome will result from situations where producers and all other economic actors pursue their own interests. 

(“Neither of which assumption bears any resemblance to the real world”,  like James Montier suggested, “Adam Smith’s invisible hand in mathematically obtuse fashion.”)

And by Milton Friedman in 1970 [1], “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits…”

Following Jensen and Meckling in 1976, they argued that “the key challenge when it came to corporate governance was one of agency theory – effectively how to get executives (agents) to focus on maximizing the wealth of the shareholders (principals)”

+ “Under an “efficient” market, the current share price is the best estimate of the expected future cash flows (intrinsic worth) of a company

-> so combining EMH led to the idea that agents could be considered to be maximizing the principals’ wealth if they maximized the stock price. “

–> This eventually led to the idea that in order to align managers with shareholders they need to be paid in a similar fashion. 

“Monetary compensation and stock ownership remain the most effective tools for aligning executive and shareholder interests.”

 

Widespread Adoption of the Bad Idea

Statements like

“Corporations have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment…provide jobs, and build the economy.”

“The principal objective of a business…is to generate economic returns to its owners…if the CEO and the directors are not focused on shareholder value, it may be less likely the corporation will realize that value.”

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-18-18-06

“I’ve shot myself in the foot by showing this example?”

スクリーンショット 2016-10-02 18.21.08.png

But single cases can explain nothing, so we move from the micro to the macro

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-18-23-14The second set of bars adjusts the total real return data to account for shifts in valuation, which reflect the price that the market is willing to put upon those returns.

-> a significant proportion of the returns achieved in the era of SVM actually came from the price investors were willing to pay

 

What went wrong for SVM?

In the last decade some two-thirds of total CEO compensation has come through stock and options.

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-18-28-34

The reason for higher pay and lower outcome is that “incentives don’t always work in the way that one might expect”

Behaviour economics shows that when incentives get too high, performance get low.

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-18-39-56

In the era of SVM, both the lifespan of a company and the tenure of the CEO have shortened significantly. [2]

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-18-43-01

SVM and the Damage Done [3]

1) declining and low rates of business investment;

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-18-49-06

<- Given the shortening lifespan of a corporate and the decreasing tenure of the CEO, the finding that many managers are willing to sacrifice long-term value for short-term gain probably shouldn’t be a surprise.

スクリーンショット 2016-10-02 18.55.18.png

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-19-02-22“the average investment rate among private firms is nearly twice as high as among public firms, at 6.8% versus 3.7% of total assets per year.”

<-  with both the shareholders have increased power and the managers will acquiesce as they are paid in a similar fashion under SVM,  we should expect SVM to lead to increased payouts but the fact is high cash return.

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-19-09-35

It play an important role, because a little known fact is that almost all investment carried out by firms is financed by internal sources (i.e., retained earnings).

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-19-12-09

From the mid 1980s onwards, equity issuance has been net negative as firms have bought back an enormous amount of their own equity (and geared themselves by issuing debt – a massive debt for equity swap). [4]

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-19-16-00

When market valuations were high (prior to the financial crisis) a record number of buybacks were conducted.

In all, the obsession with returning cash to shareholders under the rubric of SVM has led to a squeeze on investment, and a potentially dangerous leveraging of the corporate sector. 

2) rising inequality

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-18-49-20

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-19-19-04

Remember, the wealth benefits most in capital markets.

We’ve seen a similar picture in the house market, see.

Also, CXOs have been paid more than 30 years ago.

スクリーンショット 2016-10-02 19.22.31.png

スクリーンショット 2016-10-02 19.24.09.png

The rise in incomes of the top 1% has been driven largely by executives and those in finance.

3) a low labour share of GDP

%e3%82%b9%e3%82%af%e3%83%aa%e3%83%bc%e3%83%b3%e3%82%b7%e3%83%a7%e3%83%83%e3%83%88-2016-10-02-18-49-36

During the last two expansions the income gains have gone entirely (and most recently more than entirely) to the top 10%.

スクリーンショット 2016-10-02 19.25.29.png

-> The problem with this is that the 90% have a much higher propensity to consume than the top 10%.
-> Thus as income (and wealth) is concentrated in the hands of fewer and fewer, growth is likely to slow significantly.

スクリーンショット 2016-10-02 19.27.53.png

The 90% have a savings rate of effectively 0%, whilst the top 1% have a savings rate of 40%.

 

 

[1]

“It is quite staggering just how many bad ideas in economics appear to stem from Milton Friedman. Not only is he culpable in the development of SVM, but also for the promotion of that most facile theory of inflation known as the quantity theory of money. Most egregiously of all, he is the father of the doctrine of the “instrumentalist” view of economics, which includes the belief that a model should not be judged by its assumptions but by its predictions.” 

We once talked the last idea a little bit, see.

“Given Friedman’s loathing of all things Keynesian, there is a certain delicious irony that the corporate world is so perfectly illustrating Keynes’ warning of being a slave of a defunct economist!”

[2]

In the 1970s, the average lifespan of a company in the S&P 500 was 27 years (already down massively from the 75 years seen in the 1920s!). In the latter half of the last decade, the lifespan of a corporate in the S&P 500 had declined still further to a paltry 15 years.

In parallel to this trend, the average tenure of a CEO has fallen sharply as well. In the 1970s, the average CEO held his position for almost 12 years. More recently this has almost halved to an average tenure of just six years. It is little wonder that CEOs may be incentivized to extract maximum rent in the minimum time possible given the shrinkage of their time horizons (not independent of the shrinkage in time horizons for investors perhaps).

[3]

That isn’t to say that SVM alone is responsible, rather it is part of broader set of policies that have magnified these effects.

[4]

A fact first noted by Corbett and Jenkinson in 1997.

One of the most common raison d’êtres for stock markets that gets offered up is that they are providing vital capital to the corporate sector – the evidence suggests that this is nothing more than a fairy tale. Far from providing capital to the corporate sector,8 shareholders have been extracting it from corporates.